The Film Industry: Investing Essentials

Hollywood may be home to the film industry, but in recent years the industry has gone global.

In some ways, the film industry is doing as well as it ever has. Epic adventures that appeal to tweens, teens, and a growing global audience are earning billions at the box office.

Why? Technology has made it easier to create different types of stories. Studios are also marketing to audiences located in corners of the world that only a few years ago didn't have access to American cinema. The addressable market is bigger.

And yet some truisms remain. Cyclicality, for one: Consumers tend to spend more at the cineplex during tough economic times, generally as a means of escape from the difficulty of everyday life. The year-to-year variances can make it tough for investors in this sector. Here's a primer for anyone currently invested in, or thinking of investing in, the film industry.

What is the film industry?

Although it's easy to think of "Hollywood" as a catchall term for describing the film industry, the truth is that most U.S. companies involved with filmmaking aren't headquartered in Southern California. Several other nations also boast bustling film industries: India and China, notably, though Nigeria also has a growing appetite for cinema.

Before we get into the components of the film industry, let's talk about what it takes to make a movie. Generally, there are five stages:

  • Development: A screenwriter sells a script to a studio. Or, in the case of an adaptation, the studio secures rights and names a screenwriter. A premise for the final narrative is agreed upon. Financing is secured and a budget is set.

  • Pre-production: By this point, the studio has hired a director whose job it is to bring the script to life. Sets are built and locations chosen. Remaining cast and crew are hired.

  • Production: After months of preparation, the cast and crew travel to various locations to film the footage we'll see on screen.

  • Post-production: Perhaps the longest and most grueling part of the process. The director teams with editors, visual effects artists, and composers to turn the raw footage obtained during production into a fully scored movie ready for audiences.

  • Distribution. Either via its own distribution arm or through a third party, the studio negotiates financial terms with theater owners for the right to to show the film in their cineplexes.  

All told, the process can take two to three years, or even longer.

How big is the film industry?

According to The-Numbers.com, U.S. theaters sold 1.34 billion tickets in 2013, resulting in $10.9 billion in revenue. Theaters probably claimed about half that the total, with the remainder split between producers (i.e., studios) and distributors (i.e., other studios).

Why half? An often-used rule of thumb is that theaters get 50% of the cut, a figure that's supported by public data. For example, in 2013, Regal Entertainment  (NYSE: RGC  ) kept 47.7% of gross admissions revenue after paying film rental and advertising costs. AMC Entertainment (NYSE: AMC  ) kept 47.1% of of revenue from ticket sales over the same period.

(Industry rule of thumb: To determine whether a film is likely to be box-office profitable, take half the worldwide gross revenue and then subtract 150% of the budget to account for both production and marketing and distribution costs. What's left is a decent estimate of gross profit. The overall point being that estimating marketing and distribution as half of the production won't get you a perfect model for profitability, but it might get you close -- and that's a model we can comfortable with as investors since our goal is never precision. Rather, we're after good, intellectually sound process.)

The worldwide market is tougher to determine. Researcher IBISWorld has nevertheless pegged the total at $90 billion, with 58,100 businesses and 860,000 employees and contractors participating.

How does the film industry work?

For investors' purposes, the film industry is generally composed of three elements: producers, distributors, and theater operators. This isn't to diminish all of the on-screen and behind-the-camera talent that goes into making movies. Rather, I'm simplifying what can be a remarkably difficult and byzantine industry facing increasing competition.

Richer home entertainment options have made it easier to avoid the cineplex. That, in turn, has increased pressure on studios to produce blockbusters that can earn big in their first two weeks of release. Some of Hollywood's biggest names are making fewer movies in response. According to Box Office Mojo, Walt Disney's (NYSE: DIS  ) Buena Vista Pictures released 10 films in 2013 versus 19 in 2003. Sony  (NYSE: SNE  ) and Columbia Pictures released 31 movies last year, down from 43 a decade earlier.

Yet U.S. box office revenue has been on the rise in recent years as the film industry turns to technology and premium experiences such as 3D and IMAX (NYSE: IMAX  ) o boost ticket prices. In 2013 alone, the average ticket price increased to $8.13 from $7.96 the year prior.

We can expect more of that in the years to come as chains turn crowded auditoriums into luxury suites that offer not only filmed entertainment but also dinner and drinks. That same experience should also lend itself to the computer graphics-infused blockbuster fare coming out of Hollywood: big-ticket, high-adventure epics partially shot in a premium format and best enjoyed in a theater that supports premium playback. Think of Avatar, or Marvel's The Avengers.

What drives the film industry?

Moviemaking has changed dramatically in recent years. Richer home entertainment options have made it easier for audiences to skip the cineplex and wait for a favorite story to show up "on-demand." As a result, studios are under pressure to deliver standout projects that won't exit domestic cinemas after a couple of weeks.

Foreign markets have proven to be more forgiving. Indeed, it's not uncommon for a new movie to open overseas first and then earn 50% or more of its worldwide grosses in foreign territories. And in some cases, a strong international gate has more than made up for a weak response at U.S. theaters. Take Pacific Rim, which earned more than 75% of its $411 million worldwide gross from foreign markets. China, in particular, accounted for $111.9 million in ticket sales versus just $101.8 million stateside.

Yet the film industry still gets a huge chunk of its revenue and profits from home entertainment products. DVD, Blu-ray, and digital download sales, certainly, but also syndication through broadcast, cable, and pay-TV as well as streaming services. Sticking with the Pacific Rim example: Guillermo Del Toro's monsters-vs.-giant robots epic generated $22.4 million in combined U.S. home video revenue. Overseas sales may have come in much higher but those figures aren't available. Either way, a 2017 sequel is planned.

The entire film industry seems destined to follow the same pattern, whereby blockbusters win a core audience overseas first, building buzz for a big U.S. debut driven by premium screenings, followed by months of marketing premium Blu-ray editions and downloads before finally settling into syndication and a sequel. We've entered the franchise era of filmmaking.

While that won't eliminate the cyclical nature of the business -- grosses were down 20% for the summer of 2014 despite an improving economy -- it does favor the big studios that own the most "franchisable" properties, such as Disney with its princesses, Pixar, Marvel superheroes, and most recently, Star Wars. Invest accordingly


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